Bonds with Embedded Call Options

A bond can be structured with an option that allows the issuer or holder to benefit from changes in the economic environment. A call option allows an issuer to call a bond if declining interest rates drive the bond’s price above a specified call price (also known as a strike price). This option greatly benefits the issuer who can then re-issue new bonds at a lower cost of capital. Call options present a great risk for investors. Because bonds are generally called during periods of low interest rates, investors become vulnerable to reinvestment risk.

Callable bonds generally exhibit less price volatility relative to noncallable bonds during periods of declining interest rates. This is principally attributable to the existence of the call price. A callable bond’s value will not increase significantly above its call price because of the high probability that the call option will be executed.

Questions:

1. What is a call option?
    

2. How does the existence of the call price affect a callable bonds price volatility?

Answers

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